Betting Against the Shorts: One of 2013′s Best Trading Tactics

We analyze short interest data from the exchanges as soon as it’s released every two weeks for one reason:

It works!

A recent report in the Wall Street Journal revealed that short sellers are having one of their worst years in a long time[1] as the market’s trickle higher has squeezed the bears. But this bad news for hedge funds and other money managers that have been shorting the rally is good news for those investors that use this contrarian indicator to identify stocks ready to pop.

From our perspective, short interest is an effective indicator because it represents two variables that can drive a stock higher.

First, short interest data identifies when the crowd is growing too bearish toward a stock. It’s often said that the best time to buy is when everyone else is bearish — well, short data literally lets you see when the short selling crowd has reached an extreme, indicating that a stock might have reached a point where selling pressure has been exhausted and is ready to turn higher.

Short interest also is unique in that it represents an indication of potential buying pressure. The term “short squeeze” is commonly used to describe the phenomenon that often helps stocks continue with a parabolic climb.

The theory is simple … and painful for those on the wrong side of the trade. Short sellers borrow shares, then sell them with the intention of buying them back at a lower price. The problem comes when the shares go higher, not lower, and the short sellers get forced to cover their positions. The poetic justice of the short squeeze is that the same traders that were betting against a stock turn into the buyers that propel prices higher for the rest of us.

The Wall Street Journal said that “In the Russell 3000 index, the 100 most heavily shorted stocks are sharply outperforming the average returns of stocks in the index, according to a Journal analysis of data provided by S&P Capital IQ. The shorted stocks are up by an average of 33.8% through Aug. 16, versus 18.3% for all stocks in the index.”

Our own research shows that the most heavily shorted stocks in the S&P 500 (using average daily volume as a filter) in June outperformed the index more than twofold. The top 20 shorted stocks in the broader index returned an average 8.9% while the S&P 500 gained 3.9% for the same period. The least-shorted stocks underperformed the market by gaining slightly less than the S&P 500, returning only 3.4%.

Shocker.

So, simply put, our application of short interest analysis is this: We find heavily shorted stocks with healthy technical trends, then ride them to profits. Here are a few examples of our short squeeze calls from the past few months:

How about our bullish call[2] on Tripadvisor (TRIP[3]) just ahead of a 30% move in the stock last month?

We also covered PetSmart (PETM[4]) in a short squeeze commentary[5] before it headed 7% higher in the following few weeks, doubling the S&P 500’s performance in that time.

Last week, we profiled Scotts Miracle-Gro (SMG[6]) as a short squeeze candidate[7]. The stock is only up a few percent, sure, but it has only been about a week — plus, the market is actually down from that point. Who doesn’t like a winner when the market’s losing?

We’ll highlight another round of short squeeze plays in the next few days as we pore through the latest short interest data.

As of this writing, Johnson Research Group did not hold a position in any of the aforementioned securities.

Endnotes:

short sellers are having one of their worst years in a long time: http://online.wsj.com/article/SB10001424127887323423804579024883191034634.html